Political problems of governments intervening in financial firms

Financial Express, 30 April 2009

There is a political backlash worldwide about the `bailouts' of financial firms in general, and the bonuses of employees of bailed-out firms in particular. This sense of moral outrage needs to be tempered for three reasons:

  1. The term `bailout' suggests that government money is being given to the owners of these financial firms. But most of the time, this is not the case. The shareholders of firms like Bear Stearns or AIG have got wiped out. The people who are being bailed out are the households with deposits or insurance policies. (Note that in India, government intervention into PSU financial firms leaves the erstwhile shareholders unaffected; taxpayers are the only ones who suffer).
  2. The history of financial crises shows that governments get back a lot of the money that they put into these temporary interventions in finance. The really important problems are those of market structure and moral hazard, and not the short-run fiscal costs. If GDP growth is just slightly higher in coming years as a consequence of government interventions, the increased tax revenues generate enough money to justify the interventions.
  3. Most important, it is better to be pragmatic and not moralistic: these interventions are unpleasant, but they are the fastest way to put the economy back on track.

The political problems of governments and financial sector crises are epitomised by the trouble at AIG. For some weeks, newspapers and television channels in the US went berserk with hatred of AIG employees who got bonuses of $165 million. The popular portrayal was one of a hubristic greedy company taking money from the government bailout and paying it out to the fat cats. This meme started out on the `The New York Times' edit page, and travelled into tabloids and late night shows.

This turns out to be a populist portrayal. The bonuses paid out by AIG were 0.097% of the size of the bailout. Too many individuals are unable to tell that there is a 1000-fold difference between $165 million (bonuses) and $170 billion (bailout). The decision to pay these bonuses was taken by Edward Liddy, the new CEO who was brought in at a salary of $1 at the request of the government. The bonuses are spread amongst 463 individuals, averaging $356,000 per person, which is a quarter of the average bonuses of their peers on Wall Street.

The AIG episode was an important battle, one that the Obama administration lost. Timothy Geithner, Larry Summers and Ben Bernanke are extremely competent people, but they are not politicians. What was needed when the AIG problem erupted was for a politician like Obama to go out on national television and nip the problem in the bud. This was not done in time. The administration has lost much political capital in the process.

When Obama got started, the scenario was one of a new administration, armed with adequate political capital, that would get going and solve the problems of the economy. Now the picture is more sombre. By and large, there is optimism that Geithner's proposals will get bad assets off the books of the banks. But in the process, the banks will need a substantial equity capital injection, to fill in the gap created when bad assets are sold at below book value. In addition, further fiscal stimuli are likely to be required by the end of this year. The Obama administration is likely to face political constraints in (a) recapitalising banks and (b) reforming financial regulation properly. The danger in both cases is that an administration that faces political constraints, and agrees to either a watered down solution that will not work, or (worse) a populist solution that will actually do damage. An example of the former would be a bank recapitalisation that still leaves them fragile. An example of the latter would be a regulatory and supervisory stance which would, unlike the Paulson or Geithner plans, hamper growth in coming decades.

The larger lesson out of this episode is focused on the erroneous connotations of the word "bailout" as argued at the outset of this article. The larger community needs to understand that in a financial crisis, what is being bailed out are the households of the country and not the shareholders of the financial firms. Politicians need to step forward and speak clearly about these issues to the public at large. If this can be done successfully, then financial crises will pose fewer problems in coming decades.

In the meantime, on Wall Street, a host of medium sized firms (some old and some new) are rising out of the wreckage. They do not suffer from the problems of the giant firms. They are attracting the best staff away from the big firms, since they have no difficulties on paying salaries or bonuses. Many of the best brains of the big firms are stepping out and starting companies. In the medium term, 2009 and 2010 might turn out to be a turning point for the big firms of Wall Street, in terms of the altered competitive landscape.

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